Berkshire Hathaway 1999 Annual Meeting Audience Question # 63

Derivatives is “a business that people can get in trouble in and they can get in trouble while the accounting sails along merrily”

Warren Buffett:

The question about the derivatives business, it’s a good business… it’s a good question… because it involves big balance sheet numbers and big off-balance sheet numbers in relation to the amount of money made, and particularly in terms… in relation to the amount of money made in terms of the capital employed.

And the credit guarantees, the long-term nature, all of that makes that something that we will want… we do want to look at always very hard.

It’s a business that people can get in trouble in and they can get in trouble while the accounting sails along merrily.

I remember when Charlie and I were at Salomon, we found… we didn’t find it, other people found it finally, but… mismarked derivative positions that were very substantial that had gone on for a long period of time.

And this was with paying a lot of money to auditors to look at them.

Am I right about that, Charlie, on that? Charlie was on the audit committee.

Charlie Munger:

The worst glitches were that the books just got so out of control, not in the derivative department, but there were just multimillion dollar errors.

Warren Buffett:

But we found mismarks, as I remember…

Charlie Munger:

Yes.

Warren Buffett:

…in the 20-odd millions on…

Charlie Munger:

Yes.

Warren Buffett:

…positions…

Charlie Munger:

Yes. Both.

Warren Buffett:

In some cases, because the contracts got so complicated that the people that were valuing them didn’t understand them, and… at least partially didn’t understand them.

There’s a lot of potential for mischief when people can write down a few numbers on a piece of paper and nothing changes hands for a long time and their compensation, you know, next month and this year, depends on what numbers are attached to a bunch of things that are not really… where they don’t come to fruition for a long time. And particularly when you’re guaranteeing credit or anything of the sort.

So, you’re very correct in observing that, when the numbers are big in relation to the amount of profits, you want to look very carefully, because if anything goes wrong, it could go wrong on a fairly big scale, and you’re not getting paid a lot for running that type of risk.

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